Chapter22 Production and Cost

CHAPTER 22
Production and
Costs
©2016 Cengage Learning. All Rights Reserved. May not be scanned,

copied or duplicated, or posted to a publicly accessible website, in
whole or in part.
 The Firm
 Explicit Cost and Implicit Cost
INTHISLECTURE
 Economic Profit and Accounting Profit

 Production and Costs in the Short Run
 Production and Costs in the Long Run
 Sunk Cost
 Shifts in Cost Curves
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CH 22 • 2
BUSINESS FIRM
● An entity that employs factors of

production (resources) to produce goods
and services to be sold to consumers,
other firms, or the government.
MARKET COORDINATION – INVISIBLE
HAND
● The process in which individuals
perform tasks, such as producing
certain quantities of goods, based on
changes in market forces, such as
supply, demand, and price.
MANAGERIAL COORDINATION AND
BUSINESS FIRMS – VISIBLE HAND
● The process in which managers direct
employees to perform certain tasks.
WHY DO BUSINESS FIRMS ARISE IN THE
FIRST PLACE?
Firms are formed when benefits can be
obtained from individuals working as a
team.
Sum of Team Production > Sum of

Individual Production
PROBLEM OF AND SOLUTIONS FOR
“TEAM” WORK
Problem: Shirking - The behavior of a
worker who is putting forth less than
the agreed to effort.
Solution: Monitor – Person (manager) in a
business firm who coordinates team
production and reduces shirking.
Problem: Monitor shirking
Solution: Make the monitor a Residual
Claimants - Persons who share in the
profits of a business firm.
WHY FIRMS EXIST AS AN ALTERNATIVE TO
HAVING A SEPARATE CONTRACT WITH EACH
FACTOR OF PRODUCTION - RONALD COARSE
“The costs of negotiating and concluding a separate contract for
each exchange transaction which takes place on a market
must also be taken into account. . . .
It is true that contracts are not eliminated when there is a firm,
but they are greatly reduced. A factor of production (or the
owner thereof) does not have to make a series of contracts as
would be necessary, of course, if this co-operation were a
direct result of the working of the price mechanism. For this
series of contracts is substituted one.
At this state, it is important to note the character of the contract
into which a factor enters that is employed within a firm. The
contract is one whereby the factor [the employee], for a
certain remuneration (which may be fixed or fluctuating),
agrees to obey the directions of an entrepreneur within
certain limits.” Ronald Coarse.
MARKETS: INSIDE AND OUTSIDE THE
FIRM
 Economics is largely about trades or
exchanges; it is about market transactions.
 In supply-and-demand analysis, the
exchanges are between buyers of goods and
services and sellers of goods and services.
 In the theory of the firm, the exchanges take
place at two levels: (1) at the level of
individuals coming together to form a team
and (2) at the level of workers “choosing” a
monitor.
FIRM’S OBJECTIVE: MAXIMIZING
PROFIT
● The difference between total revenue
and total cost.
Profit = Total revenue - Total cost
EXPLICIT AND IMPLICIT COST
 Explicit Cost - A cost incurred when an

actual (monetary) payment is made.
 Implicit Cost - A cost that represents
the value of resources used in
production for which no actual
(monetary) payment is made
(opportunity cost).
ACCOUNTING, ECONOMIC AND
NORMAL PROFIT I
 Accounting Profit - The difference between

total revenue and explicit costs.
 Economic Profit - The difference between
total revenue and total cost, including both
explicit and implicit costs.
 Normal Profit - Zero economic profit. A firm
that earns normal profit is earning revenue
equal to its total costs (explicit plus implicit
costs). This is the level of profit necessary to
keep resources employed in that particular
firm.
ACCOUNTING, ECONOMIC AND
NORMAL PROFIT II
1. Will individuals form teams
or firms in all settings?
SELFTEST
No. Individuals will form teams or firms
only when the sum of what they can
produce as a team (or firm) is greater
than the sum of what they can
produce working alone.
2. Suppose everything about two people is the
same except that one person currently
earns a high salary and the other person
SELFTEST
currently earns a low salary. Which is more
likely to start his or her own business and
why?
The person earning the low salary has lower implicit costs
and so is more likely to start a business. She gives up less to
start a business.
3. Is accounting or economic
profit larger? Why?
SELFTEST
Accounting profit is larger. Only explicit
costs are subtracted from total revenue in
computing accounting profit, but both
explicit and implicit costs are subtracted
from total revenue in computing economic
profit. If implicit costs are zero, then
accounting profit and economic profit are
the same. Economic profit is never greater
than accounting profit.
4. When can a business owner be earning a
profit but not covering his costs?
A business owner can be earning a profit but not covering
SELFTEST
costs when he is earning (positive) accounting profit but
his total revenue does not cover the sum of his explicit and
implicit costs. For example, suppose Brad earns total
revenue of $100,000 and has explicit costs of $40,000 and
implicit costs of $70,000. His accounting profit is $60,000,
but his total revenue of $100,000 is not large enough to
cover the sum of his explicit and implicit costs ($110,000).
Brad’s economic profit is a negative $10,000. In other
words, although Brad earns an accounting profit, he takes
an economic loss.
PRODUCTION AND COST:
FIXED AND VARIABLE INPUTS
 Production is a transformation of
resources or inputs into goods and
services
 Fixed Input - An input whose
quantity cannot be changed as output
changes.
 Variable Input - An input whose
quantity can be changed as output
changes.
PRODUCTION AND COST:
SHORT AND LONG RUN
 Short Run - A period of time in which
some (at least one) inputs in the
production process are fixed.
 Long Run - A period of time in which
all inputs in the production process can
be varied (no inputs are fixed).
MARGINAL PHYSICAL PRODUCT (MPP)
 Marginal Physical Product (MPP) - The

change in output that results from
changing the variable input by one
unit, holding all other inputs fixed
∆𝑄
𝑀𝑃𝑃 =
∆𝐿
PRODUCTION IN THE SHORT RUN AND
THE LAW OF DIMINISHING MARGINAL
RETURNS
 In the short run, as additional units of
a variable input are added to a fixed
input, the marginal physical product of
the variable input may increase at first.
 Eventually, the marginal physical
product of the variable input decreases.
 The point at which marginal physical
product decreases is the point at which
diminishing marginal returns have set
in.
LAW OF DIMINISHING MARGINAL
RETURNS
● Law of Diminishing Marginal Returns
- As ever-larger amounts of a variable
input are combined with fixed inputs,
eventually, the marginal physical
product of the variable input will
decline.
PRODUCTION IN THE SHORT RUN AND
THE LAW OF DIMINISHING MARGINAL
PRODUCTIVITY
FIXED, VARIABLE, TOTAL AND
MARGINAL COST
 Fixed Costs (FC) - Costs that do not vary
with output; the costs associated with fixed
inputs.
 Variable Cost (VC) - Costs that vary with
output; the costs associated with variable
inputs.
 Total Cost (TC) - The sum of fixed costs and
variable costs. TC = TFC + TVC
 Marginal Cost (MC) - The change in total
cost that results from a change in output: MC
= ΔTC/Δ Q.
MARGINAL PHYSICAL PRODUCT AND
MARGINAL COST I
MARGINAL PHYSICAL PRODUCT AND
MARGINAL COST II
 The marginal physical product of labor curve is derived
by plotting the data from columns 2 and 4 in the exhibit.
 The marginal cost curve is derived by plotting the data
from columns 3 and 8 in the exhibit. See next slide.
RELATIONSHIP BETWEEN COST AND
PRODUCTIVITY
W = Wages (variable cost)
MPP = Marginal Physical Product
MC = Marginal Cost
HOW MPP AFFECTS MC
AVERAGE PRODUCTIVITY
When the press or laypersons use the word

productivity, they are usually referring to
average physical product instead of marginal
physical product. To illustrate the difference,
suppose 1 worker can produce 10 units of output
a day and 2 workers can produce 18 units of
output a day. Marginal physical product is 8
units (MPP of labor = ∆Q/ ∆L). Average physical
product, which is output divided by quantity of
labor is equal to 9 Units
𝑄
𝐴𝑃 𝑜𝑓𝑙𝑎𝑏𝑜𝑟 =
𝐿
LABOR PRODUCTIVITY
● Labor productivity is used in the

newspaper and in government
documents, it refers to the average
(physical) productivity of labor on an
hourly basis. By computing the average
productivity of labor for different
countries and noting the annual
percentage changes we can compare
labor productivity between and within
countries.
1. If the short run is 6 months, does it
follow that the long run is longer than
6 months? Explain your answer.
SELFTEST
No. The short run and the long run are not lengths
of time. The short run is that period of time when
some inputs are fixed and therefore the firm has
fixed costs. The long run is any period of time when
no inputs are fixed (i.e., all inputs are variable) and
thus all costs are variable costs. The short run can
be, say, six months, and the long run can be a
much shorter period of time. In other words, the
time period when there are no fixed inputs can be
shorter than the time period when there are fixed
inputs.
2. “As we add more capital to more
labor, eventually the law of
diminishing marginal returns will set
SELFTEST
in.” What is wrong with this
statement?
The law of diminishing marginal returns holds only
when we add more of one input to a given (fixed)
quantity of another input. The statement does not
identify one input as fixed (it says that both
increase), and so the law of diminishing marginal
returns is not relevant in this situation.
3. Suppose a marginal cost (MC) curve falls
when output is in the range of 1 unit to 10
units, flattens out and remains constant over
an output range of 10 units to 20 units, and
SELFTEST
then rises over a range of 20 units to 30
units. What does this have to say about the
marginal physical product (MPP) of the
variable input?
When MC is declining, MPP is rising; when MC is constant,
MPP is constant; and when MC is rising, MPP is falling.
AVERAGE FIXED, VARIABLE AND
TOTAL COST
 Average Fixed Cost (AFC) - Total
fixed cost divided by quantity of output:
AFC = TFC / Q.
 Average Variable Cost (AVC) - Total
variable cost divided by quantity of
output: AVC = TVC / Q.
 Average Total Cost (ATC), or Unit
Cost - Total cost divided by quantity of
output: ATC = TC / Q.
TOTAL, AVERAGE & MARGINAL COSTS
I
TOTAL, AVERAGE & MARGINAL COSTS
II
AVERAGE-MARGINAL RULE
● When the marginal magnitude is above

the average magnitude, the average
magnitude rises; when the marginal
magnitude is below the average
magnitude, the average magnitude
falls.
TYING SHORT-RUN PRODUCTION TO
COSTS
What happens in terms of production (MPP rising or falling) affects MC, which in turn
eventually affects AVC and ATC.
SUNK COST
 A cost incurred in the past that cannot

be changed by current decisions and
therefore cannot be recovered.
 Economists advise individuals to ignore
sunk costs.
1. Identify two ways to compute average
SELFTEST total cost (ATC).
ATC = TC/Q and ATC = AFC + AVC
2. Would a business ever sell its product
for less than cost? Explain your
answer.
SELFTEST
Yes. Suppose a business incurs a cost of $10 to make
a product. Before it can sell the product, though, the
demand for it falls and moves the market price from
$15 to $6. Does the owner of the business say, “I
can’t sell the product for $6 because I’d be taking a
loss?” If she does, she chooses to let a sunk cost
affect her current decision. Instead, she should ask
herself,” Do I think the market price of the product
will rise or fall?” If she thinks it will fall, she should sell
the product today for $6.
3. What happens to unit costs as marginal costs rise? Explain
your answer.
Unit costs are another name for average total costs (ATC);
so the question is what happens to ATC as MC rises? You
SELFTEST
might be inclined to say that as MC rises, so does ATC, but
this is not necessarily so. What matters is whether MC is
greater than ATC. If it is, then ATC will rise. If it is not, then
ATC will decline. This is a trick question of sorts. There is a
tendency to misinterpret the average-marginal rule and to
believe that as marginal cost rises, average total cost rises
and that as marginal cost falls, average total cost falls. But
the average-marginal rule actually says that when MC is
above ATC, ATC rises, and when MC is below ATC, ATC
falls.
4. Do changes in marginal
physical product influence unit
costs? Explain your answer.
SELFTEST
Yes. As marginal physical product (MPP)
rises, marginal cost (MC) falls. If MC falls
enough to move below unit cost (which is
the same as average total cost), then unit
cost declines. Similarly, as MPP falls, MC
rises. If MC rises enough to move above unit
cost, then unit cost rises.
PRODUCTION AND COSTS IN THE
LONG RUN
 In the short run, there are fixed costs
and variable costs; therefore, total cost
is the sum of the two.
 A period of time in which all inputs in
the production process can be varied
(no inputs are fixed). In the long run,
there are no fixed costs, so variable
costs are total costs.
LONG-RUN AVERAGE TOTAL COST
CURVE (LRATC )
 There are three short-run

average total cost curves
for three different plant
sizes.
 If these are the only plant
sizes, the long-run average
total cost curve is the
heavily shaded, blue
scalloped curve.
LONG-RUN AVERAGE TOTAL COST
CURVE (LRATC )
 The long-run average

total cost curve is the
heavily shaded, blue
smooth curve.
 The LRATC curve is not
scalloped because it is
assumed that there are
so many plant sizes that
the LRATC curve touches
each SRATC curve at only
one point.
ECONOMIES OF SCALE I
 Economies of Scale exist when inputs are

increased by some percentage and output
increases by a greater percentage, causing
unit costs to fall.
 Constant Returns to Scale exist when
inputs are increased by some percentage and
output increases by an equal percentage,
causing unit costs to remain constant.
 Diseconomies of Scale exist when inputs
are increased by some percentage and output
increases by a smaller percentage, causing
unit costs to rise.
 Minimum Efficient Scale - The lowest
output level at which average total costs are
minimized.
ECONOMIES OF SCALE II
 Economies of scale → LRATC is falling

 Constant returns to scale → LRATC is
constant
 Diseconomies of scale → LRATC is
rising
WHY ECONOMIES OF SCALE?
 Up to a certain point, long-run unit costs of

production fall as a firm grows. There are two
main reasons for this:
 Growing firms offer greater opportunities for
employees to specialize.
 Growing firms can take advantage of highly
efficient mass production techniques and
equipment that ordinarily require large setup
costs and thus are economical only if they can
be spread over a large number of units.
WHY DISECONOMIES OF SCALE?
In very large firms,

managers often find it
difficult to coordinate
work activities,
communicate their
directives to the right
persons in satisfactory
time, and monitor
personnel effectively.
ECONOMIES OF SCALE II
The lowest output level

at which average total
costs are minimized.
SHIFTS IN COST CURVES
A firm’s cost curves will shift if there is a

change in:
Taxes
Input prices
Technology.
1. Give an arithmetical example to
illustrate economies of scale.
It currently takes 10 units of X and 10 units of Y to
SELFTEST
produce 50 units of good Z. Let both X and Y double
to 20 units each. As a result, the output of Z more
than doubles—say, to 150 units. When inputs are
increased by some percentage and output
increases by a greater percentage, then economies
of scale are said to exist. When economies of scale
exist, unit costs fall, and another name for unit costs
is average total costs.
2. What would the LRATC curve
look like if there were always
constant returns to scale?
SELFTEST
Explain your answer.
The LRATC curve would be horizontal. When
there are constant returns to scale, output
doubles if inputs double. If this happens, unit
costs stay constant. In other words, they
don’t rise and they don’t fall; so the LRATC
curve is horizontal.
3. Firm A charged $4 per unit when it produced 100
units of good X, and it charged $3 per unit when it
produced 200 units. Furthermore, the firm earned the
same profit per unit in both cases. How can this
SELFTEST
happen?
Unit costs must have been lower when it produced 200
units than when it produced 100 units. That is, there were
economies of scale between 100 units and 200 units. To
explain further, profit per unit is the difference between
price per unit and cost per unit (or unit costs): Profit per
unit Price per unit Cost per unit. Suppose the unit cost is
$3 when the price is $4—giving a profit per unit of $1. Next,
there are economies of scale as the firm raises output from
100 units to 200 units. Unit costs must fall—let’s say to $2 per
unit. If price is $3, then there is still a $1 per-unit profit.
WALL STREET JOURNAL
The Wall Street Journal is a is a rich

source of information which provides
real life examples of micro- and macro
economic activities. Check today’s
issue to see the most current news.
http://www.wsj.com

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CHAPTER 22

©2016 Cengage Learning. All Rights Reserved. May not be scanned,

 Economic Profit and Accounting Profit

● An entity that employs factors of

Sum of Team Production > Sum of

 Explicit Cost - A cost incurred when an

 Accounting Profit - The difference between

 Marginal Physical Product (MPP) - The

When the press or laypersons use the word

● Labor productivity is used in the

● When the marginal magnitude is above

 A cost incurred in the past that cannot

ATC = TC/Q and ATC = AFC + AVC

 There are three short-run

 The long-run average

 Economies of Scale exist when inputs are

 Economies of scale → LRATC is falling

 Up to a certain point, long-run unit costs of

In very large firms,

The lowest output level

A firm’s cost curves will shift if there is a

The Wall Street Journal is a is a rich

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